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Tickers in this Article: rnwk, msft, yhoo, goog, twx, nws, amzn, aapl, via
Looking at the performance of RealNetworks (RNWK) shares over the past twelve months, it's easy to assume the stock has a lot going for it. Sure, the company is sitting on a big cash pile thanks to its court settlement with Microsoft (MSFT) over digital media software. And the company appears to be delivering strong profitability.

But take a closer look closer, and you'll spot a few problems that RealNetworks won't easily escape. Even with the stock riding close to its all-time highs, fierce competition is knocking at RealNetworks door.

Competition is likely to get especially hot in the fastest growing music, video and games business where RealNetworks makes most of its money.

The Internet's heaviest hitters -- Yahoo! (YHOO), Google (GOOG), Time Warner's (TWX) AOL, Microsoft, News Corp's (NWS), Amazon (AMZN), Apple (AAPL) and Viacom (VIA) – either have existing products or have announced new ones that go head-to-head with Realnetworks.

If it even hopes to hold its own against these big competitors, RealNetworks faces the painful prospect of much higher development and marketing spending.

Besides, investors should be darn worried about the future of the RealPlayer. For years, the RealPlayer online music and video player has been the company's ticket to grabbing subscribers on the cheap.

The trouble is, as more websites embed their music and video content, fewer users need the RealPlayer (or Microsoft's Media Player, for matter) to watch video clips on YouTube, Yahoo!, Google, etc.

As this trend continues, the problem of declining traffic growth could get a whole lot worse for RealNetworks.

So far, RealNetworks has been able to maintain robust gross margins. But looking ahead to higher spending and falling traffic numbers, it doesn't take much of an imaginative leap to foresee its profitability erode.

Of course, the company is taking steps to diversify its revenue streams. Using some of the $761 million it got from Microsoft, RealNetworks has acquired WiderThan, which supplies ring back tones, music and other mobile entertainment to wireless telecom carriers for $350 million.

But to deliver the growth it needs from WiderThan, RealNetworks will probably need to spend that $350 million figure again to effectively promote the wireless service. The cost of growth is going to be high.

Insider selling ought to make investors pause for thought. Since the first half of the year, CEO Rob Glaser, Senior VP Michael Shutzler, Director James Breyer, Senior VP Carla Stratford and Senior VP Daniel Sheeran have sold stock.

Then there's the stock's valuation to consider. Wall Street analysts are expecting RealNetworks' 2006 earnings per share to be about 75 cents, which puts the stock on a multiple of 13 times earnings. At first glance, that sounds pretty cheap.

But stripping out the one time proceeds gained from the settlement with Microsoft, the PE multiple jumps to a staggering 120 times earnings. Even by the standards of the richly-valued Internet sector, that number looks awfully high.

Call me a grump, but you should think twice before loading up on RealNetworks these days.

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